With Treasury yields back near historic lows, income-starved investors hunting for additional revenue streams have turned to exchange traded funds that invest in real estate investment trusts.
With bond yields scraping along the bottom and interest rates depressed until mid-2013, investors are looking to other forms of investments that offer any slight chance of decent yields. As a result, REITs have attracted their fair share of market interest. Assets in the ETF category surged 60% over the past year, party due to market appreciation. The asset class climbed nearly 200% since the March 2009 lows and gained more than two times the broader U.S. market.
REITs are securities that are traded like stocks on major exchanges. REITs can hold physical properties that generate revenue from rent payments, or REITs may be mortgaged based, which means they invest in property mortgages through either loaning money for mortgages or purchasing existing mortgages and other mortgage securities. A hybrid type REIT holds both mortgages and physical properties.
The Different Forms of REITs
Retail REITs provide the average retail investor with exposure to the commercial real estate market, such as shopping malls, office buildings or warehouses.
Residential REITs own or operate multi-family rental apartment buildings and manufactured housing.
Healthcare REITs invest in hospitals, medical centers, nursing facilities and retirement home homes. Since a majority of operators rely on fee reimbursements, health care funding will be a major factor driving performance.
Office REITs invest in office buildings and receive rental income on long-term leases. The state of the economy, unemployment rate, vacancy rates and capital are all deciding factors in this sub-sector.
Mortgage REITs account for around 10% of REIT investments. Increases in interest rates could decrease mortgage REIT book values and future financing would be more expensive.
How REITs Work
The companies generate revenue from rent collected on properties. REITs then pay out a hefty chunk of their net income to shareholders through dividends in order to qualify for federal tax breaks.
By pooling the assets together, REITs reduce risk and provide greater diversification since capital is distributed through numerous properties. If an individual were to mimic such a strategy, one would have to buy multiple properties, which is of course impractical for the average person.
Investments in REITs are also a more efficient diversifier since REITs are more liquid as opposed to investments tied to physical property. REITs are a good way for investors to add a new asset class to their portfolio, and they typically show a low correlation to conventional assets like stocks and bonds. This investment class has proven to maintain its strength during stock downturns compared to the broader market indicators, although REITs were hit hard during the financial meltdown in 2008 and 2009.
Currently, the commercial mortgage backed securities (CMBS) market is showing a remarkable recovery as total volume is expected to double year-over-year for 2011. Rising rental rates in key markets, the reinvigorated capital markets and a promise that interest rates will remain at record lows have all helped support the CMBS market.
REITs have also benefited from a steady increase in office, retail and apartment rent prices and the recruitment of additional tenants. The REIT asset class is expected to continue to show strength, as long as job growth can support the higher rents and tenant demand.
The Caveat
The largest risk that REIT investors face is the ability of the companies to collect rent. If the commercial side of the market weakens, then that could over time weaken the yields to the point that shareholders no longer find them of value. Additionally, GDP, corporate profits and consumer confidence are also major factors to consider when gauging economically-sensitive REIT ETFs. But most of these factors hinge on the well-being of the job market.
Economists, though, do not expect job growth to quickly pick up any time soon as the recovery in both the U.S. and European economies remain uncertain on debt concerns and potential defaults.
Furthermore, interest rates are already at very low levels. As interest rates eventually increase, REITs may experience higher costs in capital, diminished cash flows and depressed asset values. But, with the Federal Reserve leaving rates alone until 2013, there is not an immediate worry on increasing rates.
REIT ETF Options
The largest REIT ETF is the Vanguard REIT Sector ETF (VNQ), with $9.0 billion in assets and 106 holdings. VNQ has an expense ratio of 0.12% and a current yield of 3.21%. The fund provides exposure to a diversified range of the various REITs, such as industrial and office buildings, residential, hotels, and other real estate property.
Among the more targeted REIT ETF options, the iShares FTSE NAREIT Mortgage REITs Index Fund (REM) is the largest, with $221.0 million in assets and 49 holdings. REM has an expense ratio of 0.48% and its current yield is 10.99%. This type of REIT ETF provides a targeted exposure to a specific area of the real estate market. In the case of the REM ETF, mortgage REITs, which include residential and commercial real estate, make up 73.62% of the overall holdings of the fund and 21.24% of the fund comes from banks that provide mortgage financing.
Investors who want to diversify REIT investments through global holdings may consider international REIT ETFs that target specific countries or regions. SPDR Dow Jones International Real Estate ETF (RWX) is the biggest, with $2.1 billion in assets. RWX has an expense ratio of 0.59% and yields 9.99%. The fund has a significant portion of its holdings in real estate operating companies, diversified, regional malls and office space. The ETF invests more than a third of its assets in Japan and Australia.